On Knightian Uncertainty

An interesting post appeared recently attempting to distinguish between risk and uncertainty. The view was proposed by an economist called Frank Knight. The theory proposed by Knight is that risk is something where the outcome is unknown but whose odds can be estimated. But when the odds become inestimable, risk turns to uncertainty. In other words, risk can be measured and uncertainty cannot.

There are economists who argue that Knight's distinction only applies in theory. In the world of the casino, where the probability of a 21 turning up or the roulette ball landing on a certain number can be estimated, it is possible to have risk. But anything outside simple games of probability becomes uncertainty because it is difficult to measure the uncertainty. The real world out there is so complex that it is indeed difficult to make even reasonably short term projections, let alone the really long term ones. So what is really the truth here? Does risk (as defined by Knight) even exist in the world today? Or as the recent world events (be it 9/11, the Great Recession, the threatened collapse of Greece, the oil spill in the Gulf of Mexico, the unpronounceable Icelandic volcano) have revealed, it is a mirage to try and estimate the probability of something playing out with remotely close to the kinds of odds we initially estimate.

I have a couple of reactions. First, my view is that risk can be measured and outcomes predicted more or less accurately under some conditions in the real world. When forces are more or less in equilibrium, it is possible to have some semblance of predictability about political and economic events. And therefore an ability to measure the probability of outcomes happening. When forces disrupt that equilibrium and the disruptions may be caused by the most improbable and unexpected causes, then all bets are off. Everything we have learnt from the time when Knightian risk applied is no longer true and Knightian uncertainty takes over.

Second, this points to the need for the risk management philosophy (as it is applied to a business context) to not only consider what the system knows and can observe but also the risks that the system doesn't even know exist out there. That's where good management practices such as constantly reviewing positions, eliminating extreme concentrations (even if they appear to be value-creating concentrations), constantly questioning the cognitive thinking - can lead to a set of guardrails that a business can stay within. Now these guardrails may be frowned up and even may invite derision from those interested in growing the business during good times, as the nature of these guardrails are always going to be to try and avoid too much of a good thing. However, it is important for the practitioners of risk management to stay firm to their convictions and make sure the appropriate guardrails are implemented.

Quantifying the tails - Another interesting book

One of my readers Rusen pointed to another very interesting (if somewhat specialized) book which deals with quantifying extreme or once-in-a-hundred-years events. The name of this book is "Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets" by Nassim Nicholas Taleb.

Taleb talks about events that occur at the extreme end of a probability distribution, where we think our models work but they models break down (because of a number of reasons). Taleb presents a perspective around where we should depend on models and where our intuition should tell us not to trust the models.

If readers want a preview of what's there in the book, check out this website www.fooledbyrandomness.com. (Taleb is releasing a second book this month called "The Black Swan: the impact of the highly improbable".)

Some interesting books on risk and probability

My holiday reading in India is two books I have been planning to read for a while now, but never really found the time.

One is "Against the Gods: The Remarkable Story of Risk" by Peter Bernstein. People who have read Peter Bernstein will know what to expect. Very detailed coverage of fairly arcane concepts without getting into too many technicalities. A good jumping board to get into the actual academic papers. (Something I love doing is to pick these books and then search for the bibliography, esp. academic papers. Very interesting exercise and highly encouraged for those amongst us who want to know a little more.). I should post a review of the book in the next few weeks. For those who want to read another quality book from Peter Bernstein, try "Capital Ideas".

Second is a book called "Chances are: Adventures in Probability" by Kaplan and Kaplan. I am midway through this book. Again very informative and entertaining. The underpinnings of insurance is particularly interesting. (Bayes is coming up in the next chapter. I am super excited!)

A third book I really enjoyed was "When Genius Failed" by Roger Lowenstein. Hope to start a discussion about the book very soon, as I see very immediate application with what LTCM went through and my current line of work. (No, I don't work with a hedge fund.)

Even while I am adding stuff about these books, do try and grab them from the local library or better still, own them. They will give make for pleasurable reading for many many years, I promise. For those living in Fairfax County in Virginia, USA, the library system has all of these books.